Thank You

Error.

Alexander Friedman and Mark Haefele first crossed paths on a camping trip in 1989 organized for incoming freshmen at Princeton. Now 42, they are together again, playing a major role in overseeing about $1.7 trillion of assets held by clients of UBS Wealth Management and its affiliates. They both joined the Swiss firm nearly two years ago. Friedman is global chief investment officer of UBS Wealth Management and UBS Wealth Management Americas, and Haefele is head of investment at UBS Wealth Management. About $130 billion of the money they manage is in discretionary accounts.

Cautiously optimistic about the global economy, Friedman and Haefele are finding opportunities in high-yield debt, insisting the rally in such bonds isn't over. They also have been allocating more money to emerging-market corporate debt. On Jan. 2, they began overweighting global equities, although they have liked the U.S. stock market for more than a year.

Based in Zurich, Friedman and Haefele draw on the firm's 900 analysts across various asset classes and regions, as well as outside investors, to help shape their views. "It is both a UBS and an external process," says Friedman.

Friedman: As we see it, the global economy rests on three legs: the U.S. economy, as well as those of Europe and China. Europe looks like an elderly couple that had some health problems and went to the doctor. They got shots, and they are feeling better about things. But, basically, they are still old, with major health problems. Still, they feel a lot better than they did six months ago before the doctor helped them out.

China is on the other end of the spectrum. China looks like a 21-year-old that is superfit and feels like it can do anything. There is no obstacle it can't overcome; that's a risk of being 21. At that age, you often find yourself getting injured in sports because you don't really yet know your limit.

Where does that leave the U.S.?

Friedman: It is somewhere in the middle. It looks like a 45-year-old that used to be superfit, but now has kind of let itself go. So it is unclear if it has the will—in this case through the political process—to get itself fit again.

Haefele: For much of the past year, many investors and we were focused on the key risks and what potentially could go wrong. Now, for the first time, the risks are probably equally weighted against what could go right this year, particularly in some of the developed-market economies. For one thing, global GDP [gross domestic product] growth is picking up. We see it accelerating to 3% this year. In China, as there were concerns about a slowdown in GDP growth, fixed-asset investment has been working very well. We've seen growth picking up. We saw a 7.9% GDP-growth number recently, and we are looking for an uptick to 8% in 2013. We've seen lending and liquidity expand in China as well.

Do you really believe those numbers? Skeptics like noted short seller Jim Chanos say China is being built on a credit bubble.

Friedman: That is primarily why I refer to China as the 21-year-old. It is hard to know if they have the judgment that's necessary, but they do have the strength. Another thing to consider is that the export and import data don't always match in China. The banks are like a faucet for the government's policies, and their balance sheets are a bit opaque. It is hard to get the overall statistics right for China. But since the fourth quarter, we have seen a clear improvement in private-sector profits. Iron-ore prices and low steel inventories show you that real demand is picking up. From a price/earnings perspective, Chinese equities are attractively valued.

Haefele: One of the interesting statistics is that about 75% of the local-government loans outstanding in China have been refinanced recently. The turnaround in GDP growth from 7.4% to 7.9% was driven by the government. In the longer term, China has demographic issues, and will have to switch more toward a consumer society from one heavily reliant on investment. But when are they going to make that shift in earnest, and are they going to be able to balance it? Those are harder questions. We don't know when China is going to slow, but in the next six months, we are positive.

Friedman: The future potentially looks different, whether you are talking about market performance or the real economy. What has happened to reduce the risk [of a major destabilizing event]? The expansion of central-bank balance sheets to almost 12% of global GDP from about 5.5% in 2008. I can argue with you about whether central-bank actions will transmit real growth to the economy, but I wouldn't [argue] that financial risk is down or financial repression has boosted risk assets. Equity markets started the year on a good note, but some of the data, even in the U.S., suggest confidence isn't there yet. Europe's structural issues haven't been solved, unemployment is great, and there is no growth. So there are the markets, and then there is the economy.

What is the outlook for Europe?

Haefele: We see Europe coming out of a recession this year. An interesting fact: Portugal can now borrow for five years at what it could borrow at for five months less than a year ago. The risk premium has declined. Similarly, the Spanish 10-year yield is now around 5%, and Greece's is around 10%. We are seeing something of [European Central Bank President Mario] Draghi's positive contagion. The Ifo index, which surveys the business climate in Germany, recently beat expectations. But on the flip side, concerns about structural problems have been pushed off, but could resurface.

Which structural problems come to mind?

Friedman: Spain has 26% unemployment, which doesn't speak of a continent turning the corner. It speaks to huge overhang problems around growth and demographics. But the exciting news is that Europe is emerging from a recession to just over zero-percent growth. Still, we aren't thrilled about the overall story in Europe yet, and the demographics are a major problem there as well.

What about the U.S.?

Haefele: The U.S. has benefited from a strong belief that its central bank will provide a backstop as a lender of last resort, something in question in Europe for perhaps some of 2012. We have seen some positive signs in the U.S. The ISM [Institute for Supply Management] index is above 50, indicating economic expansion. Existing home sales are at their highest level since 2007, and we are wondering what kind of impact an improving home market will have on the wider U.S. economy. The other thing we've seen is that a lot of deleveraging has taken place in U.S. households. But there are also risks, including politics.

Most investors tend to use a short time frame in evaluating the U.S. They study the last event as an indication of the direction things are going. But the fiscal cliff, for instance, was a symptom of political issues, not the problem itself. What causes the tension will be around for a long time.

What have you been telling clients about asset allocation?

Haefele: For many clients, the emphasis remains on liquidity and security, and that often means high-grade sovereign bonds. But one of our biggest concerns is explaining to clients that these supposedly safe assets are, in fact, now becoming risky. An 18-basis-point rise in yield wipes out a whole year's return on a five-year Treasury [a basis point is a hundredth of a percentage point]. Getting them to understand that what was safe may now be dangerous, and things considered more dangerous, such as equities, might now be safe, is a difficult conversation.

Perceptions of volatility in the equity market haven't changed that much. It is a conversation about getting people to accept that volatility isn't the same as a permanent loss of capital, but that's what many investors will be facing with their sovereign-bond exposure.

You are recommending high-yield bonds, but others think the junk-bond rally is long in the tooth. Why are you sanguine?

Friedman: First, corporate balance sheets in the U.S. haven't been in better shape in a long time. So, the overall high-yield-bond outlook is supported by a low default profile. Central-bank activity is heading in the right direction, and, frankly, high-yield debt is attractively valued in terms of its risk premium over U.S. Treasuries, even after the rally.

The second reason we like high yield is that the overall default rate for high-yield issuers was about 1½% at end of 2012, versus a long-term median of about 4%. So, from a risk perspective, it is pretty attractive. Then, consider that almost $370 billion of high-yield debt was issued in 2012, much of it to refinance maturities coming up.

What do you like about emerging-market debt?

Haefele: We have done a lot of work in emerging-market corporate bonds, and we've recently increased our allocation there. This is a $1 trillion market that is not particularly well known. It is larger than the emerging-market sovereign-debt market, and, because it is less well known, we are looking at a pickup in yield, even though the average rating on the corporate-bond index is a notch higher than on the sovereign index.

Last month, you switched to an overweight on global equities, although you had been overweighting U.S. equities for more than a year. What's to like about stocks?

Haefele: We wanted to see that the politicians in the U.S. weren't going to drive off the cliff at the end of last year. Concerns about political factors remain, but we are also seeing an uptrend in global growth. There has been a decline in profit growth globally. It has declined about 18% since mid-2011, largely due to falling profit margins. But margins are starting to stabilize, which is going to support equities.

We are also seeing stronger momentum in the markets, even though there is a disparity in fund flows. For example, United Kingdom pension funds have the majority of their assets in bonds now, instead of equities, for the first time since the 1950s. We are looking for some of this gap to begin to close. Over the longer term, equity valuations will help equity performance. We look at cyclically adjusted earnings yields compared to bond yields, and we feel equities are about 20% undervalued. That valuation gap doesn't have to close in the short term, but it is nice to have that support, given our thesis that some other factors will begin to turn around and drive risk premiums lower.

Why do you like U.S. mid-cap stocks?

Friedman: They are mostly exposed to the U.S. economy, more than giant companies like
General ElectricGE -1.234076433121019%General Electric Co.U.S.: NYSEUSD24.81
-0.31-1.234076433121019%
/Date(1427835616984-0500)/
Volume (Delayed 15m)
:
33679270AFTER HOURSUSD24.829
0.01900000000000190.0765820233776703%
Volume (Delayed 15m)
:
1254354
P/E Ratio
16.400052882072977Market Cap
252895608448.982
Dividend Yield
3.7081821846029825% Rev. per Employee
488328More quote details and news »GEinYour ValueYour ChangeShort position
(ticker: GE) are. If you believe there is going to be a turnaround in the U.S., as we do, mid-caps are a more focused play. As for sectors, we are underweight telecoms and utilities in the U.S. We are more interested in many cyclicals, because they are underpriced. Our biggest overweight is IT [information technology], which we see benefiting from increased corporate and consumer spending. Valuations are attractive, and it is a long-term, logical, and compelling trend.

The industrial sector is also attractive because it is poised for an improvement in business capital spending. Inventories are lean; there are increasing signs of business investment. The materials sector is another overweight for us, mostly as a play on global growth, particularly in commodity-intensive emerging economies.

Are investors too late in trying to catch the rally in equities?

Friedman: It depends if you are a trader or an investor. If you are a trader, it might feel like it's too late. But you have to look at it as an investor. The U.S. has a dynamic economy. It has a possible path to energy independence, and the ability to generate new companies. This would suggest that cyclically adjusted equity valuations are attractive. No, they are not too late.